MYTH OF THE TWO PARTY SWAP
| Read comments | Add comment / Rate this Article | Article by: Timothy Halligan |
The practice of Exchanging has come a long way since the Service issued definitive regulations on the application of IRC §1031 to deferred Exchanges in 1991. However, many myths still persists regarding the Exchange transaction which, incorrectly and unnecessarily limit the practice and application of IRC §1031 and its usefulness as a tax planning tool.
The most frequently voiced myth is that all Exchanges must be two property swaps. The myth goes like this. An Exchange transaction is a concurrent swap of properties by two parties, Jack and Jill, each desiring benefits under IRC §1031. In order to effect the Exchange, Jack and Jill will agree that the value of their properties are similar or dissimilar by a specific amount and that they will each convey a deed to the other in a simultaneous transfer of deeds. If the values are different Jack will either give Jill cash or other non like kind property or receive cash or other non like kind property from Jill to balance the values. Both Jack and Jill will report the swap as an Exchange. If the value of Jack’s property given in the swap is less that the value of Jill’s property, then Jack’s Exchange will be fully tax deferred and Jill’s will be partially tax deferred.
Although the swap between Jack and Jill is a valid Exchange under IRC §1031 it is not a practical Exchange. In the real world, it is unlikely that a swap will occur. To complete a two party swap:
1) Jack must find Jill. Jill owns property she no longer desires. She is willing to take title to Jack’s property as full or partial consideration for the transfer of her property to Jack;
2) Jack must desires to own Jill’s property in Exchange for conveying title to his property to Jill. Jack’s market for replacement property for his Exchange is severely limited to Jill or others with similar needs.
3) Jack and Jill must agree that the value of the properties are equal or if unequal they must agree that the values differ by a specific amount that can be made up by the giving and receiving of non like kind property.
4) If Jack and Jill are related parties, both Jack and Jill must retain the property received in the Exchange for a minimum period of two years. If either party sells the property received before the expiration of the two year period, then neither party shall benefit from the non-recognition treatment afforded under IRC §1031.
It is no wonder that few Exchanges are accomplished as two party swaps. If the two party swap was the only applicable form of an Exchange, then Exchanges would, for all practical purposes, not occur. However, this is not he case.
To eliminate the practical issues of the swap, most Exchanges today are conducted as delayed Exchanges utilizing four principals.
Jack desires to conduct the transfer of his property as a qualifying Exchange. He will convey his property to an independent forth party principal, a “Qualified Intermediary” (“QI”) who will sell the property to Rachael. Rachael is strictly a buyer, any buyer, who wants to acquire Jack’s property and who is willing to pay cash in an amount acceptable to Jack. Rachael does not own the property Jack wants to receive as replacement property in the Exchange.
When the QI sells Jack’s property to Rachael, Rachael pays the purchase price to the QI, not to Jack.
Jack then locates Jill. Jill has property Jack wants to acquire in the Exchange. However, she is not a party to Jack’s Exchange nor does she desire to benefit from an Exchange under IRC §1031. Jill simply wants to sell property.
Jack instructs the QI to purchase Jill’s property using the cash the QI is holding from the sale to Rachael. Upon the close of escrow Jill conveys her deed to the QI, the QI transfers the funds to Jill and to conclude the Exchange, the QI transfers title to Jill’s property to Jack.
1) Jack and the QI accomplished a swap. Jack conveyed title to his property to the QI to commence the Exchange and the QI transferred Jill’s property to Jack in conclusion of the Exchange. A two party swap between Jack and the QI has been fabricated using Rachael as a buyer and Jill as a seller.
2) Jack’s market for the sale of his property is unlimited. Rachael is any buyer who is ready, willing and able to acquire Jack’s property for cash. Rachael does not have to own the property Jack wants.
3) Jack’s market for the replacement property is also unlimited. Jill is any seller who desires to sell the property Jack wants for cash. Jill does not have to want Jack’s property in Exchange.
4) The Exchange between Jack and the QI is made up of two typical purchase and sale transactions, one between the QI and Rachael and the second between the QI and Jill. All of the specifics of the Exchange are handled exclusively between Jack and the QI and outside of Rachael and Jill.
Since 1991 almost all Exchange transactions have been handled as four party delayed Exchanges. The mechanics of all such transactions are conducted as described and eliminate all of the inherent problems associated with the two party swap.
This information is not intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.
